Editor's Note: This article has been amended to better reflect Atlantic Power's debt position.
At the end of May, utility stocks were rapidly sold off following a multi-month rally as investors took profits and sought more cyclical opportunities in a rising market.
But, after this pullback, could now be the time to buy?
The majority of the utility sector still looks overvalued, as investors have been chasing valuations higher during the past few months and years in the hunt for yield. However, it appears that there are still some undervalued companies in the market.
Basically I am looking for a company that is trading for less than the value of its assets and that is profitable, well-capitalized and has a low level of debt. So, based on that brief, I have four screening criteria:
- Price-to-book ratio - ideally below one, but no more than two times
- Current ratio - equal to or greater than 1.5
- Debt-to-equity ratio - ideally below one but this is flexible; ideally interest costs should be covered at least twice by gross income
- Some earnings - the company must have generated some EPS growth during the past five years
- Dividend - the company must offer a dividend
Company number one is Companhia Paranaense de Energia (ADR) (COPEL), which is engaged in the distribution and sale of electricity in the state of Paran, Brazil. The company currently appears undervalued with a P/B ratio of 0.8 and a P/E ratio of 8.1.
COPEL has a current ratio of 1.8 and a debt-to-equity ratio of 18%. Over the last five years, the company has generated EPS growth of 2.5%, around 0.5% a year, and this slow rate of growth is one of the reasons behind the company's low valuation.
That said, COPEL is expected to grow EPS 17% this year and generate a return on equity of 10%, relatively high for its sector considering the company's 10-largest peers have an average ROE of between 7% and 9%.
COPEL's dividend yield is 3.4%, although last year's payout of $0.52 per share is covered just under four times by EPS.
Overall, COPEL looks cheap due to its low price-to-book ratio, low price-to-earnings ratio, strong return on equity and strong balance sheet. Additionally, with a dividend cover of nearly four times, there is plenty of scope for COPEL to raise its dividend payout.
Company number two is NRG Energy . NRG operates within the US, acquiring, developing and managing power stations and related infrastructure. NRG is currently on offer with a P/B ratio of 0.8 and a P/E ratio of around 12.2.
NRG has a current ratio of 1.5 and a debt-to-equity level of 160%, higher than I would like; however, the company is able to cover its interest costs 2.8 times from gross profit.
NRG has achieved EPS growth of 4.3% during the past five years and like COPEL, this slow growth and low yield of 1.9% are the reasons for the company's low valuation.
Unfortunately, NRG has underperformed during the past few years, but it could be in the process of changing its fortunes.
Renewable energy could be the next great investment and NRG is well positioned to take advantage of this. NRG is the nation's largest developer of solar power, with a growing portfolio of large solar plants and installations at sports stadiums, commercial buildings and homes.
In addition, the company is targeting the electric-vehicle market by developing a network of 'home-and-away' charging stations for battery-powered vehicles within Texas.
Overall, NRG is well positioned to take advantage of the renewable energy revolution and is currently trading below the value of its assets.
Stock number three is highly speculative but the reward could justify the risk. Atlantic Power has not had a good year so far; to date, the stock has fallen around 59% after the company slashed its dividend by 60%.
Although, there could be an opportunity here as even after its 60% cut, the company still offers a dividend yield of around 8%. Furthermore, after the dividend cut, the company is easily able to afford its payout from operating cash flow with room to spare.
Moreover, Atlantic Power is trading at a P/B ratio of 0.8, and during the first quarter of 2013 the company produced its first positive free cash flow since 2009.
So far this year Atlantic Power has not performed well, but the company still offers a good dividend yield that is well covered.
So overall, these three utilities are cheap for a reason but they also offer value with high potential returns and their strong financial position lessens any speculation.